How 529 college savings plans work and why you should consider one over a high-yield savings account

With the cost of college rising year over year, it's hard to even imagine what the tuition sticker price will be when babies born in 2020 start college in the fall of 2038. And with all the competing expenses the average American family juggles, it's impossible to offer a one-size-fits-all answer to the question of whether and how to fund your child's college education.

But if you are beginning to think about your baby's future, you'll want to take a closer look at 529 college savings plans, so you can fully understand their benefits and drawbacks.

These types of investment plans offer incentives to encourage parents to set aside money by offering tax benefits, which includes tax-free earnings and withdrawals for qualified educational expenses. Another important feature is that assets in a 529 plan won't negatively impact your child's ability to qualify for federal aid, since it's not weighed as heavily toward the expected family contribution (EFC). The EFC is the dollar amount your family is expected to pay for a child's college education based on your financial circumstances.

Depending on where you reside, choosing your state's 529 plan may offer additional tax benefits, but you can also expand your search to look at other state's offerings. Shop around for a plan offering the best investment options and lowest fees, so you can maximize your money. 

Below, we go into more detail about why parents and guardians may want to choose a 529 plan over other types of investment vehicles, plus how to compare plans effectively to make sure you're choosing the best one for your family.

Investing in a 529 offers several advantages over other types of accounts, like taxable brokerage or even high-yield savings accounts. For one, you get several tax advantages, which can help you save on both the cost of education and your income taxes.

A 529 plan, even with its contribution limits, can help save parents a lot of money, says Andrew Wang, a financial advisor and managing partner at Runnymede Capital Management.

"You can think of a 529 account like a Roth IRA account, except it's for education purposes instead of retirement" he says. "You can save money by not paying taxes on your earnings and when you withdraw it for qualified education expenses like tuition and textbooks."

In addition, parents and guardians have the potential of earning more compared to sticking their money in a savings account. While growth isn't guaranteed, many 529 plans show an average rate of return that's higher than what you'd find with deposit accounts. 

Another option is opening a brokerage account, which may offer similar growth rates depending on your investment portfolio. Parents may like the fact that these types of accounts don't necessarily have contribution limits, says Wang, compared to 529 plans, where individuals can contribute up to $15,000 (or $30,000 for married couples) annually before the gift tax exclusion phases out. 

"Parents need to understand that a brokerage account is an investment account that doesn't have any special tax breaks," Wang says, so you gain flexibility but lose the savings. "You can withdraw the money at any time for any purpose [with a brokerage account], but you'll also be taxed on your earnings." 

Ultimately, choosing a 529 savings plan over other options means getting clear on what you want to do with your money, says Jennifer Hemphill, an Accredited Financial Counselor and host of Her Dinero Matters. 

"Someone would usually pick a 529 because one of their priorities is having money for their kid's college in order to avoid student loans as much as possible," she says. "It's a great option for families who can afford to use part of their money toward educational expenses and believe having a college education is important."

Before shopping around for 529 plans, make sure you and your family know which financial goals are most important to you. If you want to help send your child off to college with as little debt as possible, a 529 makes sense given all the tax benefits. 

Another type of 529 plan is the prepaid tuition plan. The difference between this and the 529 college savings plan is that it allows account holders to purchase credits or "units" at participating educational institutions that can be applied in the future toward tuition and fees for their child. While you can prepay for tuition, these plans don't typically cover future room-and-board costs, which is an expense covered by a 529 plan. 

The main benefit of a prepaid tuition plan is that you have the potential to save on tuition, since you're paying today's price for future tuition. However, if your child doesn't attend a specific school (typically public and in-state participating colleges), you may lose part or all of your money. Even if you're able to transfer some or all of your funds to another participating institution, the value may go down. 

"Prepaid plans are less popular today because to take advantage of its full financial benefit, the beneficiary must choose from a select few eligible institutions," Wang says. "For most people, the limitations outweigh the benefits."

Hemphill agrees, and adds it's important to look at all the pros and cons before deciding on a prepaid plan.

"Prepaid plans lock in today's college costs, but they don't cover all costs," she says. "Choosing the best plan for your family involves comparing the two options side by side and weighing what's best." 

When it comes to selecting a 529 plan, both Hemphill and Wang recommend checking whether your state offers any tax advantages. Some states, like Colorado for example, offer tax deductions on contributions made to their own state's 529 plan, but there are some states that offer an incentive such as a tax credit for a contribution to any plan). Before opting for your state plan, check to see if there's any special tax incentives and whether the advantages outweigh any drawbacks, like high fees or poor fund performance.

"Since fees can vary from state to state, it's important to see whether they'll be higher or lower if you invest in-state, turning on auto-contributions or opting for electronic statements," Wang adds. "Fees can eat up any of your contributions, so look at the fine print for things like enrollment or application fees, management fees, annual account fees and fund management fees."

Hemphill adds you should also research how you open your 529 plan. 

"If you go through a broker to open your 529, you may pay higher fees," she says. However, most 529 plans don't require you to use a broker — you can go the DIY route and potentially save thousands of dollars setting up the account yourself.  

Other considerations include minimum investment amounts, the types of investment options available and whether it's easy to navigate the plan's website. If family members and loved ones want to be able to contribute, finding a plan that makes it easy to do so is also key.

Who opens the account may also affect how much federal aid the child will be eligible for. A grandparent-owned 529 plan is considered income to the student, whereas a parent-owned 529 plan is not. Because of this difference, grandparent-owned 529 plans can reduce the amount of financial aid that a student is able to receive. However, Hemphill says that in most cases, there is a minimal impact and depends on who owns the plans, the withdrawals you are taking and the aid you are applying for. 

If you end up choosing a 529 plan you don't like, Wang suggests rolling it over into a new plan. The IRS allows one tax-free rollover each year — meaning, you can choose a plan that better suits your needs and switch without much consequence.

If your child doesn't end up going to college or you don't end up needing all your 529 savings to cover their education expenses, you have a few options. 

First, you can transfer whatever is left in the 529 plan to another child, eligible dependent or use it yourself for qualified educational needs. To do so, simply change the beneficiary on the account — your 529 plan provider will have instructions on how to.

Otherwise, you can withdraw the cash, though you'll pay a 10% penalty, plus any income taxes you may incur. You can also roll it over to a family member's ABLE account without incurring any penalties. These tax-advantaged accounts are for people who were disabled and received Social Security insurance benefits before turning 26.

A 529 plan is beneficial for parents who place importance on a college education and want to save money when making financial contributions. The advantages are too good to ignore — contributions grow tax free, and as long as you use the withdrawals for qualified education expenses, they're also non-taxable. 

No two plans are the same, so start your research with your in-state plan to see if you'll receive additional benefits such as tax credits. Comparing investment options and fees you'll need to pay, such as expense ratios, will ensure you're choosing a plan that will cost you less over the long run. 

Whichever route you choose, make sure you weigh all the pros and cons before making your choice. That way, you'll make an educated decision that will benefit both you and your family for years to come. You can start your research by looking through our list of the best 529 plans, all of which offer the lowest fees and widest range of investment options.

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